Transcript Business Organizations

Business Organizations
2009-2010 Lectures
PARTNERSHIPS,
CORPORATIONS
AND THE VARIANTS
PROF. BRUCE MCCANN
LECTURE 12
DIVIDENDS AND DUTY OF CARE
PP. 479-528
PIERCING THE CORPORATE VEIL
 The issue is not whether the corporate entity should
be disregarded for all purposes, nor whether its very
purpose was to defraud the plaintiff. Rather, the
issue is whether in the particular case and for
purposes of that case "justice and equity can best be
accomplished and fraud and unfairness defeated by a
disregard of the distinct entity of the corporate
form." (Kohn v. Kohn (1950) 95 C.A.2d 708)
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Sea-Land Rule
 Corporate entity will be disregarded and veil of limited
liability pierced if:

There is a unity of interest and ownership such that the separateness
of the personalities of the entity and the individual (or other entity)
no longer exists


Unity of interest determined by analysis of
 Lack of corporate formalities
 Commingling of corporate and non-corporate assets
 Undercapitalization
 Treating corporate assets as if belonged to owner(s)
Circumstances must be such that adherence to the fiction of
separateness would


SANCTION A FRAUD
PROMOTE INJUSTICE
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Sea-Land Rule – “Promote Injustice?”
 Means more than that a creditor will go unpaid.
 There must be a wrong beyond creditor’s inability to
collect, e.g.,



Unjust enrichment to person or entity who looted corporation
Scheme to move assets to one entity and liabilities to another
Must be sufficient to “merit the evocation” of the court’s
equitable powers.
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Declaring Dividends
 Highlights the tension between creditors and
shareholders


CREDITORS do not want money taken out of the corporation
until they have been paid
SHAREHOLDERS like dividends because
(a) represents a return on investment that is no longer subject to
market forces;
 (b) declaring a dividend signals optimism about the future and
often drives the share price higher.

Lec. 12, pp 479-528 Corporations
McCann
Prof.
Basic Policy Objective: Protect the Creditor
 Limit so that dividends can only be paid from
“surplus” after sufficient capital held in reserve to
pay debts.
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Solely Within Authority of Directors
 Holders of common shares have no vested right to a
dividend

Some preferred shares carry right to a dividend and
enforcement power (such as right to name directors) if
required dividend is not paid to preferred shareholders
 Courts will not interfere with directors’ decision to
declare or withhold dividend absent showing of
fraud, bad faith or abuse of discretion by directors
 BUT once a dividend is declared, shareholders may
enforce in court
Lec. 12, pp 479-528 Corporations
McCann
Prof.
TYPES OF SURPLUS

Capital surplus
Excess portion of price received by corporation for its stock after
subtracting the par value
 Plus any amount directors deem necessary (sometimes required by
creditors)


Earned surplus


Reduction surplus


Earning of the company from operations after subtracting liabilities
and net of capital accounts
The amount directors vote to take out of Stated Capital (e.g., by
reducing par or because augmented from capital surplus and now
unwinding
Revaluation surplus

The amount of previously unrealized appreciation directors choose to
recognize (and which moves into earned surplus)
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Approaches Vary By Jurisdiction:
 1. Can only be paid from Earned Surplus
 2. Can only be paid if balance sheet shows there is
money left over after liabilities and stated capital are
subtracted from assets (the “Balance Sheet” test).
 3. Can only be paid if there are “current profits”
(regardless of whether there is any earned surplus)
(the “nimble dividends” test);
 4. Can only be paid of assets exceed liabilities
(doesn’t consider stated capital or other equity); and
 5. Can pay so long as won’t leave company
“insolvent”
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Delaware
 Sec. 170:
 Can pay dividends from surplus (over stated capital)
or, if there is no surplus, can pay from current net
profits and last year’s net profits.

RATIONALE: If company has not been profitable such that
there is no surplus, probably cannot borrow. If law forbid the
payment of dividends until there is a surplus, much more
difficult to attract investors seeking a return on their
investment.
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Model Act
 Does not distinguish between dividends and
redemptions or other distributions, calls all of them
“Distributions”
 Requires all distributions meet two tests:


1. The “equity solvency” test – after the distribution will the
corporation still be able to pay its debts as they come due?
2. The “balance sheet” test – after the distribution, are the
remaining assets greater in value than its liabilities plus the
amounts the corporation would have to pay to shareholders
under existing agreements if the corporation were dissolved at
the time of the distribution
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Stock Dividends
 Issue additional shares in lieu of cash.
 Reasons:
 Don’t want to spend the cash but want to appease shareholders
 Want to increase voting rights of pro-board shareholders in
case of takeover bid
 Need to issue more shares to make an offering work and must
issue stock dividends to keep voting rights intact
 Drives down stock price somewhat (because more shares over
which ratios operate, such as “earnings per share”)
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Are Creditors Really Protected By These Rules?
 All decisions still made by the shareholders.
 The “real” assets of the corporation, the ones that
could readily generate money to pay creditors, aren’t
weighted any differently than assets like patents

So balance sheet test is almost meaningless to creditor
 By gaming “par” values or using “nimble dividends”
test, the creditors are put well behind the
shareholders
Lec. 12, pp 479-528 Corporations
McCann
Prof.
How Creditors Protect Themselves
 COVENANTS

“(a) Use of Proceeds. Proceeds received from the Payee
pursuant to this Note will be used by the Borrower for
working capital and general company purposes.

(b) Affirmative Covenants. Until the conversion or
repayment (or prepayment) of this Note in accordance
with the terms and conditions set forth herein, each
Borrower shall perform all covenants in this Section 4(b).
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Typical Terms
 (c) Negative Covenants. Until the conversion, repayment (or
prepayment) of this Note in accordance with the terms and
conditions set forth herein, the Borrower will not, without the prior
written consent of the Payee, undertake to do any of the following:
(i) create, issue, sell or transfer any debt securities of the Borrower
or enter into or incur other indebtedness other than indebtedness
which, together with this Note, does not exceed $200,000 in
principal amount (for purposes hereof, “Indebtedness” shall mean
any indebtedness of the Borrower for borrowed money from banks,
other financial institutions, (except indebtedness consisting of
drawing down on existing lines of credit) and any Person (defined as
natural persons, corporations, limited liability companies, limited
partnerships, general partnerships, limited liability partnerships,
joint ventures, trusts, land trusts, business trusts, or other
organizations, irrespective of whether they are legal entities));
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McCann
Prof.
Negative Covenants Continued
 (ii) (A) redeem, repurchase or otherwise acquire for consideration
any outstanding equity securities of the Borrower (or securities
convertible or exercisable into or exchangeable for equity securities
of such entity) or permit any Borrower to take such action; or (B)
declare or pay any cash or property dividend or distribution of any
kind on any class of stock or membership interest (except with
respect to ordinary course inter-company transfers and accounts of
the Borrower); (iii) make any material change in its ownership or
organization or the manner in which its business is conducted
outside of the ordinary course of its business; (iv) transfer, sell,
lease, or in any other manner convey any equitable, beneficial or
legal interest in any assets of the Borrower except inventory sold in
the normal course of business, or allow to exist on its assets any
mortgage interest, pledge or security interest , title retention device,
or other encumbrance, junior or senior to Payee, other than as set
forth herein.
Lec. 12, pp 479-528 Corps
Prof. McCann
STOCK BUY-BACKS (REDEMPTIONS)
 Clearly a Distribution of Money to the Shareholder
 Cash goes to shareholder
 Stock goes to company
 Shareholder ends up with fewer shares but there are now fewer
shares altogether, so net effect on percentage of ownership is
unaffected
 What does company have? Nothing of value. The stock it has
purchased cannot be shown as an asset because to do so would
allow any stock it issued and kept to be an “asset.”
Lec. 12, pp 479-528 Corporations
McCann
Prof.
KLANG V SMITH FOOD & DRUG
 Because the policy behind the rule that payments
must come from surplus is to prevent a board from
draining capital to the detriment of creditors, and if
surplus is determined by asset valuation, valuation at
time of determination is appropriate and it is
irrelevant whether or not the balance sheet uses
current valuations.

Therefore, balance sheet amounts are not determinative.
 Board’s determination will be accepted absent
showing of bad faith or fraud
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Prof. McCann
Why Buy-Backs?
 Often want to empty large cash holdings which
attract take-over interest.
 Repurchase tends to drive stock price up because


Now are fewer shares outstanding, giving those outstanding
shares more value
Evidences economic health, increasing confidence
 If directors issued large dividend checks instead,
shareholders would pay taxes at higher rates than if
got a “return on capital” which is a capital gains item
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Directors’ Duty of Care
 Francis v United Jersey Bank:
 Director is fiduciary of the corporation and its
shareholders
 And in the context of the business of the corporation,
may be a fiduciary to its creditors

Where there is constructive or actual trust
 Director must “discharge duties in good faith
and with that degree of diligence, care and
skill which ordinarily prudent men would
exercise under similar circumstances in like
positions”
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Francis v United Jersey Bank
 Where director breaches duty, personally liable if
negligence was a proximate cause of a loss to the
creditor or shareholder or corporation
 Plaintiff has burden of showing loss would have been
avoided if defendant had performed her duties
 Analysis includes determination of “reasonable
steps” director should have taken
 BUT causation will be inferred where reasonable to
conclude particular result from a failure to act and
that result has occurred.
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Caremark
 Director liability can be grounded on several
theories:


Liability following poor decision by board because
decision was negligent and ill advised
Liability based on failure to act where due diligence
would prevent the loss
 BUT, “absent cause for suspicion there is no
duty…to install and operate a system of
corporate espionage to ferret out wrongdoing
that they have no reason to suspect exists.”
Lec. 12, pp 479-528 Corporations
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Prof.
Caremark cont’d
 There must be a system in place adequate to
assure the board that appropriate
information will come to its attention in a
timely manner
 Failure to insist upon and maintain such a
system may render a director liable
Lec. 12, pp 479-528 Corporations
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Prof.
Caremark cont’d
 Plaintiffs must show:
 Director knew or
 Should have known were violations of law
 Took no steps to prevent or remedy
 Failure proximately caused the loss
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Prof.
Rule
 Model Act and ALI, and most statutes, allow
directors to rely on others if that reliance is
reasonable because the adviser “merits
confidence”
Lec. 12, pp 479-528 Corporations
McCann
Prof.